Sunday, November 11, 2007

A bubble on top of a bubble - finally understanding the mortgage mess

These two NY Times paragraphs finally made me understand why the financial markets are going to hell now when foreclosures are only at a modest level:

Among the fashionable new [mortgage loan] products were so-called affordability loans, like adjustable-rate mortgages (or A.R.M.’s), interest-only loans and reduced documentation mortgages. In addition to helping Countrywide win market share, those loans generated enormous profits, both in the commissions that borrowers paid and the premiums investors paid when they bought them as pools placed in securitization trusts.

Investors were willing to pay significantly more than a loan’s face value for A.R.M.’s that carried prepayment penalties, for instance, because the products locked borrowers into high-interest-rate loans with apparently predictable income streams.

Interest-only loans and reduced documentation mortgages only make sense if the mortgage company expects the housing bubble to last for many years, with no potential fall in value. That bubble-inflated value was then bundled and resold for a still higher value (a second bubble) based on the idea that the landowners will be forced to pay higher-than-market interest rates. Now the base value of home prices is bursting, and the expectation that people will be locked into high rates goes away for those who default on their significantly-devalued mortgage. In addition, government legislation may void the prepayment penalties for the rest in order to reduce the number of people kicked out of their homes.

We may get a perfect storm if the dollar devaluation forces interest rates up - still more adjustable rate mortgages become unaffordable, refinancing isn't an option, and the underlying value of these bundled mortgage loans disappears into the air.